Two courts agreed last month to certify class action lawsuits against franchisors. In Bird Hotel Corp. v. Super 8 Motels, Inc., 2007 WL 3046404 (D.S.D. Oct. 16, 2007), a group of Super 8 franchisees sought class certification on their challenge to the franchisor’s requirement that franchisees pay an additional mandatory fee on gross room sales for guests enrolled in the franchisor’s TripRewards program. The court agreed to certify that class, finding that the plaintiffs had satisfied the showing required by the Federal Rules of Civil Procedure. Specifically, the court found that the 226 franchisees that formed the class were sufficiently numerous to pursue a class action suit.

The court also found that the class presented common claims, as the franchisor had required each of the class members to pay the additional fee at issue. The court found that if the fee was invalid, then it was invalid as to each class member. The franchisor argued that commonality did not exist because some franchisees had signed addenda to their franchise agreements barring opposition to the franchisor’s marketing initiatives. Still other class members had signed amendments that arguably released the franchisor from liability. The court rejected those arguments, finding that issues related to individual franchisees’ contracts did not defeat commonality for purposes of the class analysis. The court found that it could consider those contractual issues later, while still permitting the class to proceed. Finally, the court concluded that the class representative’s claims were typical of those of other class members, and that the representative would adequately represent the class.

In DT Woodard, Inc. v. Mail Boxes Etc., Inc., 2007 WL 3018861 (Cal. App. Oct. 17, 2007), a group of former Mail Boxes Etc. franchisees who converted their stores into The UPS Store franchises sought to bring a class action suit against their franchisor. Plaintiffs alleged that the franchisor had misled them into converting their stores into The UPS Store franchises, thus breaching the California Franchise Investment Law. Plaintiffs further alleged that the franchisor had made impermissible representations to them, giving rise to common law liability as well. The trial court initially denied class certification, finding that individual factual issues predominated over common questions because each franchisee had received somewhat unique representations. On appeal, the California Court of Appeals reversed and found class certification to be appropriate.

The appeals court found that, whatever individual representations might have been made to each class member, all class members received the same core information from the franchisor. For that reason, the court concluded that each member presented common issues as to reliance on the franchisor’s representations. The court also concluded that the potential need for individual proof as to liability and damages for each franchisee could not alone defeat class certification. The court found that it could employ various means, including bifurcation of issues or use of subclasses if necessary to resolve those individual issues. Because the majority of issues to be raised by the franchisees were common, the court found that class certification should have been granted.

In Comedy Club, Inc. v. Improv West Associates, 2007 WL 2556702 (9th Cir. Sept. 7, 2007), the United States Court of Appeals for the Ninth Circuit concluded that a licensor’s in-term covenant not to compete was too broad under California law, but enforced the non-compete restriction in geographic areas where the licensee was currently operating comedy clubs. This is an important decision for franchisors who wish to enforce in-term non-compete agreements in California.

The agreement between the parties granted an exclusive nationwide right to use the licensor’s trademarks in connection with the opening and operation of Improv comedy clubs. The agreement contained a very broad in-term covenant not to compete, which prohibited the licensee from opening and operating any non-Improv clubs during the term of the agreement. The non-competition restriction extended to the entire United States and lasted until 2019. The agreement also contained a development schedule for opening new clubs. Interestingly, the agreement provided that failure to comply with the development schedule would result in revoking the right to use the licensor’s trademarks, but not termination of the agreement.

When the licensee failed to open the required number of new Improv clubs, the licensor revoked the licensee’s right to open more Improv clubs, but did not terminate the agreement. The licensee filed a lawsuit seeking a declaratory judgment that the covenant prohibiting the licensee from opening any non-Improv clubs during the term of the agreement was invalid. Following an arbitration, the arbitrator concluded that the licensee defaulted on the agreement, that the in-term covenant was valid and enforceable for the duration of the agreement, and that the licensee forfeited its rights to open Improv clubs and use the licensor’s marks. The district court confirmed the arbitration award.

On appeal, the Ninth Circuit found that the in-term covenant violated Cal. Bus. and Prof. Code § 16600 because it foreclosed competition in a substantial share of the comedy club business. Although the court noted that this particular covenant had “dramatic geographic and temporal scope,” it did not void the entire in-term covenant. In fact, the court acknowledged that in-term covenants may be necessary in the franchise context “to protect and maintain the franchisor’s trademark, trade name and goodwill.” As such, the court ordered the district court to vacate the arbitration award partially, concluding that the covenant was enforceable only in areas where the licensee currently operated clubs.

The licensor has filed a petition for rehearing in the Ninth Circuit, along with a request that all of the judges on the Ninth Circuit participate in the rehearing. Although it remains to be seen whether this decision will be modified, it appears at this point that in-term covenants not to compete in the franchise context that are reasonably limited in duration and scope remain valid and enforceable in California. Stay tuned.

The court in In re Grejda, 2007 WL 2792908 (W.D. Pa. Sept. 21, 2007), affirmed the bankruptcy court’s decision holding that a franchisee had violated his license agreement with franchisor Medicine Shoppe International (“MSI”) by operating an online mail-order pharmacy from the basement of his MSI pharmacy. The court, however, reversed the bankruptcy court’s decision awarding damages to MSI.

Anthony Grejda entered into a license agreement with MSI to operate a Medicine Shoppe pharmacy in Crafton, Pennsylvania. After entering into the agreement with MSI, Grejda and others started an online mail-order pharmacy and operated it from the basement of Grejda’s MSI pharmacy. Federal authorities raided Grejda’s pharmacies and later indicted him on a number of criminal charges, including health care fraud. Soon thereafter, MSI filed breach of contract claims seeking damages and termination of Grejda’s MSI pharmacy license agreement. The bankruptcy court found for MSI on all claims, including awarding MSI approximately $4 million in revenue that Grejda earned from the operations of the online pharmacy. On appeal, the district court reversed the monetary award, citing the principle of contract law that the proper measure of damages for breach of a covenant not to compete is the non-breaching party’s losses, not the breaching party’s gains. Since earlier litigation between the parties had established that Grejda’s online pharmacy did not use and was not associated in any way with MSI’s trademarks, and the online pharmacy had not diverted any customers of the franchisee’s brick and mortar MSI pharmacy, MSI had not proven any damages. As a result, MSI was entitled to terminate the license agreement because of the contract defaults, but it was not entitled to damages.

In finding that Grejda had breached the license agreement, therefore justifying the termination, the court agreed that Grejda had violated the license agreement’s covenant not to compete, which prohibited Grejda from having any interest in a pharmacy business operated within the territory of Grejda’s license agreement with MSI. Grejda contended that since his online pharmacy served a different customer base and no actual customers were diverted, the online pharmacy was not a competitive business within the territory and therefore its existence was not a breach of the covenant. The court disagreed, stating that even though there was no finding that any customers were diverted to the online business, that fact did not retroactively make void MSI’s legitimate interest in seeking to prevent a franchisee from operating any pharmacy-related business within the restricted territory.

The United States District Court for the Southern District of New York recently granted summary judgment in favor of a hotel franchisor facing claims of fraud, negligent misrepresentation, and negligent omission (among others), following the sale of one of its hotel brands to a third party. Century Pacific, Inc. v. Hilton Hotels Corp., 2007 WL 3036172 (S.D.N.Y. Oct. 17, 2007). Hilton Hotels Corporation owned the Red Lion Hotel chain, which it ultimately sold to an outside investor group. Plaintiffs were franchisees that had purchased Red Lion franchised hotels prior to the sale.

In opposing Hilton’s motion for summary judgment, plaintiffs pointed to evidence elicited in discovery to the effect that representatives of Hilton had made various oral assurances to plaintiffs that were inconsistent with Hilton’s later sale of the Red Lion brand. One plaintiff alleged that a Hilton representative stated that the company “intended” to keep the Red Lion brand. Yet, despite this alleged statement, this plaintiff negotiated for itself a clause in the franchise agreement enabling it to opt out of the franchise agreement if Hilton sold the brand within three years. Based on the plaintiff’s experience as a hotelier and its de facto acknowledgement of Hilton’s right to sell the brand (as evidenced by the parties’ negotiation of the opt-out clause), the court found no credible evidence that this plaintiff could have reasonably relied on any alleged assurance that Hilton “intended” to keep the Red Lion brand.

The second plaintiff was comparatively less sophisticated than the first and was not represented by counsel in its negotiations with Hilton. This plaintiff could only point to evidence that Hilton orally promised to “promote” the Red Lion brand – as opposed to an explicit statement that it “intended” not to sell. The court found that this alleged statement could not have been reasonably relied upon as a binding promise that Hilton would not sell the brand, even by an unsophisticated party. Moreover, the court found that the alleged promise to “promote” the brand would not even amount to a material false representation of fact – another necessary element of plaintiffs’ fraud and negligent misrepresentation claims.

The United States District Court for the District of Nebraska recently not only denied a plaintiff’s motion for preliminary injunction seeking to enforce a state court TRO to force Burger King to recognize the plaintiff as a franchisee, but the court converted Burger King’s motion to dismiss into a motion for summary judgment, granted the motion for summary judgment, and dismissed all claims against Burger King with prejudice. WesternConvenience Stores, Inc. v. Burger King, Corp., 2007 WL 2682245 (D. Neb. Sept. 7, 2007). Plaintiff Western had asserted that it was a lawful transferee of a Burger King franchise agreement.

In denying Western’s motion for preliminary injunction, and ultimately in granting summary judgment to Burger King, the court found that there was no franchise agreement granting Western the right to use the Burger King trademarks, that the only written agreement granting a license was between Burger King and the franchisee before Western, and that pursuant to that agreement the former franchisee was expressly prohibited from assigning or transferring that right to another without Burger King’s written consent. The court concluded that the evidence showed that Burger King never provided consent for an assignment or transfer of franchise rights to Western, and that without any written franchise agreement the Nebraska Franchise Practices Act did not apply.

The court then held that there were no facts supporting Western’s argument that Burger King breached a contract or the covenant of good faith and fair dealing. The court concluded that Western’s argument that the conduct of the parties between October 2006 and June 2007 established an implied contract ignored the fact that Burger King told Western that it needed to apply on-line for a franchise and that when Western did apply the application was unambiguously denied. Finally, the court also rejected Western’s claim that Burger King tortiously interfered with Western’s business expectancy. Rather, the court found that there was no evidence that Burger King consented to the assignment or transfer of rights from the former franchisee to any party, and that Western had neither a valid business relationship with Burger King nor a valid expectancy to continue operating a restaurant as a Burger King franchisee.

This case points out the importance of a well-drafted and unambiguous transfer provision requiring the express written consent of the franchisor, and the courts’ willingness to enforce these provisions.

In Mumford v. GNC Franchising LLC, WL 3003798 (W.D. Pa. Oct. 11, 2007), the United States District Court for the Western District of Pennsylvania denied a franchisor’s request for attorneys’ fees and costs and held that such claims must be made in pleadings, requested of the court prior to the entry of judgment, or made within 14 days after the entry of judgment in order to be considered. The franchisor, General Nutrition Corporation, had made the request for attorneys’ fees 25 days after it won a motion to dismiss federal antitrust claims brought against it by some of its franchisees. GNC argued that, as the prevailing party, it was entitled to attorneys’ fees and costs pursuant to the prevailing party clause of the franchise agreements with its franchisees. The court, however, ruled that GNC’s motion was untimely under Rule 54(d)(2)(B) of the Federal Rule of Civil Procedure, which requires the party to file motions for attorneys’ fees within 14 days after judgment.

GNC argued that it still was allowed to make the motion under Rule 52(d)(2)(A), which provides for fee recovery as an element of damages to be proved at trial, and Rule 54(c), which grants relief to the party in whose favor judgment was entered. The court ruled that GNC’s claim failed under both rules because there was no longer any underlying action to provide for the recovery, as the case had been dismissed, and because GNC had never filed a pleading in the case that asked for relief or that could have been amended to ask for the requested relief.

The court dismissed the motion without prejudice and noted GNC’s right to file a new complaint asserting claims for attorneys’ fees under its franchise agreements.

In U-Save Auto Rental of America, Inc. v. Furlo et al., 2007 WL 2684006 (S.D. Miss. Sept. 7, 2007), the United States District Court for the Southern District of Mississippi cited an arbitrator’s ruling as grounds for rejecting the franchisee defendants’ attempt to avoid arbitration. The case started in Florida state court, where the Florida-based franchisees sued U-Save, the franchisor, asserting various claims arising out of the parties’ franchise agreement. U-Save then filed a federal court action in Mississippi to compel arbitration, contending that the parties’ dispute was subject to a mandatory arbitration provision in the franchise agreement. Thereafter, the parties entered into a stipulation to stay proceedings and arbitrate “all matters” between them.

The arbitrator granted U-Save’s request that the Florida state court claims be dismissed, concluding that Mississippi law, not Florida law, applied under the franchise agreement. In response, the franchisees moved for the state court to recommence its proceedings and for the federal court to lift the stipulated stay. The federal court now has denied the franchisees’ request, directed that the arbitration should proceed, and, enjoined the franchisees from proceeding with their Florida lawsuit. In doing so, the federal court had two important holdings. First, the federal court held that choice of law issues are for the arbitrator to decide in the first instance, and, therefore, the arbitrator acted within its discretion in concluding that Mississippi law applied and in dismissing the claims filed under Florida law. Second, it was proper for the federal court to stay the state court case because the All Writs Act, 28 U.S.C. § 1651 specifically authorizes federal courts to issue “all writs necessary or appropriate in aid of their respective jurisdictions,” including the authority to stay the franchisees’ parallel state court claims. In light of these findings, the court denied the franchisees’ motion for rehearing, reconsideration, to alter or amend judgment and/or clarification and motion to stay arbitration.

This case further reinforces the importance of drafting clear choice of law and arbitration clauses and demonstrates that there are remedies available to franchisors when franchisees attempt to side-step arbitration clauses and rulings.

In International House of Pancakes, Inc. et al v. Albarghouthi et al., 2007 WL 2669117 (D. Colo. Sept. 6, 2007), a federal district court in Colorado granted a franchisor’s motion for summary judgment enforcing the termination of a franchise agreement based on, among other things, the unauthorized transfer of stock in the corporate franchisee to an existing franchisee who had been determined to be ineligible to operate an additional franchise. Although the franchisee had attempted to nullify the stock sale transfer after it learned of the franchisor’s objections, the court found that the franchise agreement had been breached when the stock was initially transferred without the franchisor’s approval – drawing an analogy to what would happen if the buyer and seller of a house agreed to void the contract of sale of a house after the transfer of title had already taken place.

In addition, the court concluded that the franchisee had breached the franchise agreement by continuing to operate the store after termination. It rejected the franchisee’s argument that the franchisor’s acceptance of rents and royalties after the termination notice had been issued somehow waived the franchisor’s objections to the franchisee’s holdover operations, noting that the filing of the lawsuit seeking to enforce the termination constituted sufficient evidence of its intent not to waive its right to terminate.

Not all of the franchisor’s grounds for termination were confirmed. For example, the franchisor claimed that an unpaid judgment for money damages entered against the majority shareholder could not be used as a basis to terminate the franchise agreement because the judgment had not be issued against the corporate franchisee itself. The court rejected the franchisor’s contention that the majority shareholder’s personal guarantee of the obligations of the franchisee agreement was an adequate basis for termination, holding that any judgment entered against the shareholder could not be imputed to the corporation.

Moreover, the court denied summary judgment in favor of the franchisor on its Lanham Act trademark infringement claims, despite the fact that it found that there was undisputed evidence of trademark infringement by the franchisee. The court gave some credence to the fact that the franchisor failed, after termination of the franchise, to remove the franchisee’s location from the store locations section of the franchisor’s website – thus contributing to customer confusion as to the legitimate use of the trademarks. Because the franchisor derived some benefit from the terminated franchisee’s continuing operations in that market and continued to advertise it as such, the court held that a decision on whether there had been trademark infringement would have to await trial.

Finally, the court granted summary judgment in favor of the franchisor on the franchisee’s counterclaims under federal and state law civil rights violations, which were based on the allegations that the franchisee was being treated differently by the franchisor than other non-Arab-American owed franchises. Among other things, the court found that a list of franchisees who were subject to default notices that contained an allegedly “disproportionate” number of Arab-American names – heavily relied upon by the franchisee – was insufficient evidence of discrimination. The court noted that it was impossible to draw any inference simply from the ratio of allegedly ethic-sounding names on such a list who received default notices.

The GPMemorandum is a periodic publication of Gray, Plant, Mooty, Mooty & Bennett, P.A., and should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and you are urged to consult your own franchise lawyer concerning your own situation and any specific legal questions you may have.

This article is provided for general informational purposes only and should not be construed as legal advice or legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have.

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